Why Analyst Recommendations Must Be Viewed In Context – Published in Noozhawk on Monday, December 3, 2012

Fundamental analysts — those who follow companies and make recommendations to buy, sell or hold their stocks — recommend companies based on a number of individual factors relating to their fundamental strengths. For investors trying to use this information to make buy or sell decisions for their portfolios, these recommendations can be beneficial, or detrimental. To use this information effectively, investors must consider each recommendation in the context of the economic and financial market within which the recommendation is made.

Fundamental analysts look at all kinds of criteria when determining their rating and recommendation on a company. They analyze things like management strength, product or service positioning in the marketplace, revenue and earnings growth over time, new product/service releases, expansion into new markets, valuations and more. Although analysts include the expected impact of economic and external financial market factors on these fundamental characteristics, they do not make their recommendations in the context of the current and expected future economic and financial market environment.

For example, Citigroup recently recommended Apple, placing a $675 price target on the stock. Apple fell from an all-time high of $705 per share to a recent low of $505, or by $200 points/28 percent, contributing to the Citi recommendation; Citi believes that the recent pull-back brought Apple’s shares down to a more reasonable valuation. Given the perceived value of the long-term fundamentals of the company, including the rapid pace of iPhone and iPad sales, and expected new product releases, these analysts believe that the stock is attractively valued and this resulted in the recommendation.
While we could debate the real value of the company, the strength of that new product release potential, and the sustainability of iPhone and iPad sales, among many other factors, my point is that none of these factors take into account the impact of outside factors from the economy and the financial markets.

Analyst recommendations can be very valuable. The time, effort and expertise required to follow a large, multifaceted company like Apple is formidable. Citi, for example, has not one, not two, but three full-time analysts following Apple. Tracking all of the information from Apple’s operations, compiling it, analyzing it and making sense of such a large body of information obviously takes a high level of skill that most investors simply do not possess. So there is certainly a need for the work that analysts perform.

To make appropriate investment decisions, however, investors must take the information provided by analysts and combine it with additional information and analysis. For example, investors need to consider the impact of current and future economic and financial market factors, such as the fiscal cliff — the expiration of the Bush-era tax cuts and new spending cuts to go into effect at the end of this year and the beginning of 2013, the debt-ceiling limit, the global economic challenges from the troubled countries in the European Union, the slowing economic growth in the United States, the current valuation of the overall stock market, seasonal issues surrounding the holidays and retail sales, consumer spending, corporate profits and much more.

Investors who make investment decisions solely based on analyst recommendations, or who take recommendations from brokers and advisers from firms making these analyst recommendations, without considering the investing environment, will very likely fail to reach their investment objectives. Blindly following the advice of these advisers is similar to watching the Weather Channel and dressing for a long walk without looking out the window. If the weatherman says it’s going to be sunny but there are dark clouds, those who fail to take their raincoats and umbrellas will likely get soaked.

Only by taking into account all information, and then evaluating each potential investment in the context of the specific investment objectives and risk tolerance of the investor, can appropriate investment decisions be made. Returning to our Apple example, those who blindly buy Apple on the Citi recommendation, with no consideration given to the pending fiscal cliff challenges, may find themselves losing money. No matter how great Apple may be, if the stock market overall suffers due to Congress and President Barack Obama failing to come to an agreement on taxes and spending cuts, Apple will very likely perform poorly, at least in the near term. By understanding the current and future investing environment — the economy and the financial markets — investors can more effectively evaluate analyst recommendations and thereby make better investment decisions that should result in better portfolio performance over time. Read on Noozhawk

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